Credit default swaps trading strategies

By: deni-pc Date: 28.05.2017
credit default swaps trading strategies

A credit default swap CDS is the most highly utilized type of credit derivative. In its most basic terms, a credit default swap is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, corporate bond investors buy credit default swaps for protection against a default by the issuer of the corporate bond, but these flexible instruments can be used in many ways to customize exposure to corporate credit.

CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, such as a downgrade, from one investor to another.

In a CDS, one party "sells" risk and the counterparty "buys" that risk. The "seller" of credit risk-who also tends to own the underlying credit asset-pays a periodic fee to the risk "buyer. CDS are designed to cover many risks, including: The following graphic illustrates the credit default swap transaction between the risk "seller," who is also the protection "buyer," and the risk "buyer," who is also the protection "seller.

Characteristics of Credit Default Swaps The credit default swap market is generally divided into three sectors: CDS can reference a single credit or multiple credits. Multi-credit CDS can reference a custom portfolio of credits agreed upon by the buyer and seller, or a CDS index.

Credit Default Swaps: An Introduction

The credits referenced in a CDS are known as "reference entities. Unlike total return swaps that provide protection against the loss of credit value irrespective of the cause, credit default swaps provide protection only against previously agreed upon credit events.

Below are the most common credit events that trigger a payment from the risk "buyer" to the risk "seller" in a CDS.

Credit Default Swap Trading Strategies

The settlement terms of a CDS are determined when the CDS contract is written. How Has the Credit Default Swaps Market Evolved? The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital.

As the credit default swaps market became more standardized and gained credibility, particularly following smooth credit event settlements in high profile cases such as WorldCom and Enron, more investors entered the market. While banks-through broker-dealers and reinsurance companies-are still both the largest buyers and sellers of credit default swaps, investment management firms are following closely.

Today, CDS have become the engine that drives the credit derivatives market.

In addition to hedging event risk, the potential benefits of CDS include:. The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk. Credit default swaps also have given rise to new arbitrage opportunities, particularly in global markets that do not have the transparency or efficiency of the U.

Conclusion The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit. This article contains the current opinions of the author but not necessarily those of Pacific Investment Management Company LLC.

Such opinions are subject to change without notice. This article has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Portfolios may use derivative instruments for hedging purposes or as part of the investment strategy.

Use of these instruments may involve certain costs and risks such as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a portfolio could not close out a position when it would be most advantageous to do so. Portfolios investing in derivatives could lose more than the principal amount invested.

Swaps are a type of derivative in which a privately negotiated agreement between two parties takes place to exchange or swap investment cash flows or assets at specified intervals in the future. There is no central exchange or market for swap transactions and therefore they are less liquid than exchange-traded instruments.

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credit default swaps trading strategies

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Home Education Investment Basics. June A credit default swap CDS is the most highly utilized type of credit derivative. In addition to hedging event risk, the potential benefits of CDS include: PIMCO Japan Ltd Toranomon Towers Office 18F , Toranomon, Minato-ku Tokyo, Japan Financial Instruments Business Registration Number: Director of Kanto Local Finance Bureau Financial Instruments Firm No.

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credit default swaps trading strategies

Valuations of the assets under management will be affected by, and fluctuate based upon, movements in prices of securities and values of derivative transactions in the portfolio, changes in financial market conditions and movements in interest rates, and financial conditions and credit worthiness of issuers of securities in the portfolio, among others.

Where investments are made in foreign currency denominated assets, the value of the assets will also be affected by movements in foreign exchange rates.

Thus, there is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; rather, the investment could suffer a loss. All profits and losses resulting from investments are for the account of the investor.

PIMCO | Investment Basics - What Are Credit Default Swaps and How Do They Work?

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